chapter 11a/24

CHAPTER 11A/24

MONOPOLYProf. Charles Fusi

11A/24-2Lecture by Prof. Charles Fusi

INTRODUCTION

In New York City, a taxicab requires a medallion as legal possession of a license to operate the taxi business.

Thus, the medallion constitutes a barrier to entry to New York City’s taxicab industry.

In this chapter, you will learn how governmentally imposed and other types of barriers to entry give rise to monopolies, or single-firm industries.


LEARNING OBJECTIVES

Identify situations that can give rise to monopoly

Describe the demand and marginal revenue conditions a monopolist faces

Discuss how a monopolist determines how much output to produce and what price to charge

Evaluate the profits earned by a monopolist

Understand price discrimination

Explain the social cost of monopolies


CHAPTER OUTLINE

Definition of a Monopolist Barriers to Entry The Demand Curve a Monopolist Face Elasticity and Monopoly Cost and Monopoly Profit Maximization Calculating Monopoly Profit On Making Higher Profits: Price

Discrimination The Social Cost of Monopolies


DEFINITION OF A MONOPOLIST

Monopolist

A single supplier of a good or service for which there is no close substitute

The monopolist therefore constitutes the entire industry


BARRIERS TO ENTRY

Question How does a firm obtain monopoly

power? Answer

Barriers to entry that allow the firm to make long-run economic profits

Barriers to entry are restrictions on who can start as well as stay in business.


BARRIERS TO ENTRY (CONT'D)

Barriers to entry include:

Ownership of resources without close substitutes

Economies of scale

Legal or governmental restrictions



Ownership of resources without close substitutes

The Aluminum Company of America (ALCOA) at one time owned most of of the world’s bauxite



Economies of scale

Low unit costs and prices drive out rivals

The largest firm can produce at the lowest average total cost



Natural Monopoly A monopoly that arises from the peculiar

production characteristics in an industry

It usually arises when there are large economies of scale

One firm can produce at a lower average cost than can be achieved by multiple firms


FIGURE 11A/24-1 THE COST CURVES THAT MIGHT LEAD TO A NATURAL MONOPOLY



Legal or governmental restrictions

Licenses, franchises, and certificates of convenience

Examples include Electrical utilities

Radio and television broadcasting



Legal or governmental restrictions Patents

Intellectual property

Tariffs Taxes on imported goods

Regulation Government enforcement of safety and

quality


THE DEMAND CURVE A MONOPOLIST FACES

The monopolist faces the industry demand curve because the monopolist is the entire industry


Recall that under perfect competition

Firm faces perfectly elastic demand curve, it is a price taker

The forces of supply and demand establish the price per unit

Marginal revenue, average revenue, and price are all the same

THE DEMAND CURVE A MONOPOLIST FACES (CONT'D)



Marginal revenue equals the change in total revenue due to a one-unit change in the quantity produced and sold



Perfect competition versus monopoly

The perfect competitor doesn’t have to worry about lowering price to sell more

In a purely competitive situation, the firm accounts for a small part of the market

It can sell its entire output, whatever that may be, at the same price



Perfect competition versus monopoly

The more the monopolist wants to sell, the lower the price it has to charge on the last unit sold

To sell the last unit, the monopolist has to lower the price because it is facing a downward sloping demand curve


FIGURE 11A/24-2 DEMAND CURVES FOR THE PERFECT COMPETITOR AND THE MONOPOLIST


Monopoly Perfect Competition

Single seller

Faces entire industry demand

Must lower price to sell more

Not all units sold for same price (MR < P)

Many sellers

Faces perfectly elastic demand

Must produce moreto sell more

All units sold for same price (P = MR)



FIGURE 11A/24-3 MARGINAL REVENUE: ALWAYS LESS THAN PRICE


ELASTICITY AND MONOPOLY

The monopolist faces a downward-sloping demand curve (its average revenue curve)

That means that it cannot charge just any price with no changes in quantity (a common misconception) because, depending on the price charged, a different quantity will be demanded


ELASTICITY AND MONOPOLY (CONT'D)

Question If a monopoly raises price, what will

happen to quantity demanded?

Hint Remember how consumers respond to a

change in price



Recall

A monopolist is a single seller of a well-defined good or service with no close substitute

Think of some imperfect substitutes.

The demand curve slopes downward because individuals compare marginal satisfaction to cost



After all, consumers have limited incomes and unlimited wants

The market demand curve, which the monopolist alone faces in this situation, slopes downward because individuals compare the marginal satisfaction they will receive to the cost of the commodity to be purchased


COSTS AND MONOPOLY PROFIT MAXIMIZATION

We assume profit maximization is the goal of the pure monopolist, just as it is for the perfect competitor


COSTS AND MONOPOLY PROFIT MAXIMIZATION (CONT'D)

Perfect competitor has only to decide on the profit-maximizing output rate because price is given The perfect competitor is a price taker

For the pure monopolist, we must seek a profit-maximizing price output combination The monopolist is a price searcher



Price Searcher

A firm that must determine the price-output combination that maximizes profit because it faces a downward-sloping demand curve



We can determine the profit-maximizing price-output combination with either of two equivalent approaches:

By looking at total revenues and total costs

or

By looking at marginal revenues and marginal costs



Total revenues-total costs approach Maximize the positive difference

between total revenues and total costs

Marginal revenue-marginal cost approach Profit maximization will also occur where

marginal revenue equals marginal cost



Question Why produce where marginal revenue

equals marginal cost?

Answer This is where the greatest positive

difference between total revenue and total cost occurs


FIGURE 11A/24-4 MONOPOLY COSTS, REVENUES, AND PROFITS, PANEL (A)


FIGURE 11A/24-4 MONOPOLY COSTS, REVENUES, AND PROFITS, PANELS (B) AND (C)



Producing past where MR = MC Result is that incremental cost will

exceed incremental revenue

Producing less than where MR = MC The monopolist is not maximizing profits

through this approach either


FIGURE 11A/24-5 MAXIMIZING PROFITS


COST AND MONOPOLY PROFIT MAXIMIZATION (CONT’D)

Real-World Informational Limitations Price searching by a less-than perfect

competitor is a process A monopolist can only estimate the

actual demand curve and make an educated guess when it sets its profit-maximizing profit

For the perfect competitor, price is given already by the intersection of market demand and supply


CALCULATING MONOPOLY PROFIT

Monopoly profit is given by the shaded area in Figure 24-6, which is equal to total revenues (P Q) minus total costs (ATC Q)


FIGURE 11A/24-6 MONOPOLY PROFIT


CALCULATING MONOPOLY PROFIT (CONT'D)

No guarantee of profits

The term monopoly conjures up the notion of a greedy firm ripping off the public

If ATC is everywhere above AR, or demand

No price-output combination allows the monopolist to cover costs


FIGURE 11A/24-7 MONOPOLIES: NOT ALWAYS PROFITABLE


INTERNATIONAL EXAMPLE: A MEXICAN CEMENT MONOPOLY FINDS A WAY TO INCUR LOSSES

In Mexico, a single company, Cemex, accounts for almost 80 percent of the nation’s cement production and sales.

Thus, Cemex sells cement to Mexican consumers at almost twice the market price in the United States, where a number of firms make and sell cement.

Recently, Cemex has been incurring losses as a result of falling demand in 2008 and its debt costs from short-term loans that the company had borrowed during periods of expansion.


ON MAKING HIGHER PROFITS: PRICE DISCRIMINATION

Price Discrimination

Selling a given product at more than one price, with the difference being unrelated to differences in cost


ON MAKING HIGHER PROFITS: PRICE DISCRIMINATION (CONT'D)

Price Differentiation

Establishing different prices for similar products to reflect differences in marginal cost in providing those commodities to different groups of buyers


ON MAKING HIGHER PROFITS: PRICE DISCRIMINATION (CONT'D)

Necessary conditions for price discrimination

1. The firm must face a downward-sloping demand curve

2. The firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand

3. The firm must be able to prevent resale of the product or service


EXAMPLE: WHY STUDENTS PAY DIFFERENT PRICES TO ATTEND COLLEGE

Out-of-pocket tuition rates for any two college students can differ by considerable amounts, even if the students happen to major in the same subjects and enroll in many of the same courses.

The reason for this is that colleges offer students diverse financial aid packages depending on their “financial need.”

To document their “need” for financial aid, students must provide detailed information about family income and wealth. This information helps the college determine the prices that different families are most likely to be willing and able to pay, so that it can engage in price discrimination.


FIGURE 11A/24-8 TOWARD PERFECT PRICE DISCRIMINATION IN COLLEGE TUITION RATES


THE SOCIAL COST OF MONOPOLIES

Comparing monopoly with perfect competition

Let’s assume a monopolist comes in and buys up every single perfect competitor

Notice the monopolist produces a smaller quantity and sells at a higher price


THE SOCIAL COST OF MONOPOLIES (CONT'D)

Comparing monopoly with perfect competition

Monopolists raise the price and restrict production compared to a perfectly competitive situation

Consumers pay a price that exceeds the marginal cost of production and resources are misallocated in such a situation


FIGURE 11A/24-9 THE EFFECTS OF MONOPOLIZING AN INDUSTRY


YOU ARE THERE: A TEXAS VETERINARY BOARD WHITTLES DOWN VETS’ COMPETITION

The Texas Board of Veterinary Medical Examiners has determined that horse-teeth floaters, who provide basic dental services for horses, must be certified or else they must work under the supervision of a licensed veterinarian.

This way, many skilled horse-teeth floaters without a license will no longer able to compete with licensed veterinarians in the market for horse dental services.


ISSUES & APPLICATIONS: THIS MEDALLION IS NOT SIMPLY A DECORATIVE PENDANT

The number of taxi medallions issued by New York City is controlled by the city’s Taxi and Limousine Commission.

The commission’s medallions serve as a barrier to entry in the taxicab market.

The medallions can be bought and sold, and the market clearing prices have generally risen since 2004, now exceeding $600,000 for individual owners and $800,000 for corporate owners.


FIGURE 11A/24-10 MARKET PRICES OF NEW YORK CITY TAXI MEDALLIONS


SUMMARY DISCUSSION OF LEARNING OBJECTIVES (CONT'D)

Why a monopoly can occur Barriers to entry

Demand and marginal revenue conditions faced by a monopolist Because the monopolist constitutes the

entire industry, it faces the entire market demand curve.

Marginal revenue is less than price.



How a monopolist determines how much output to produce and what price to charge

Seeks to maximize its economic profits

Produces where marginal revenue equals marginal cost

Charges maximum price for the amount of output where MR = MC



A monopolist’s profits

Profit earned by monopolist is equal to the difference between the price it charges and its average production cost times the amount of output it produces and sells.

Monopolist typically earns positive economic profits.



Price discrimination

Selling at more than one price with the price differences being unrelated to differences in production costs.

Monopolist sells some of its output at higher prices to consumers with less elastic demand.



Social cost of monopolies

Price exceeds marginal cost.

The price is higher and output is lower for a monopolist as compared to a perfectly competitive industry.


APPENDIX G: CONSUMER SURPLUS IN A PERFECTLY COMPETITIVE MARKET

Given the market clearing price that prevails in the perfectly competitive market, consumer surplus is: the difference between the total amount

that consumers would have been willing to pay and the total amount that they actually pay


FIGURE G-1 CONSUMER SURPLUS IN A PERFECTLY COMPETITIVE MARKET


APPENDIX G: HOW SOCIETY LOSES FROM MONOPOLY

Deadweight Loss The portion of consumer surplus that no

one in society is able to obtain in a situation of monopoly

No one in society, not even the monopoly, can obtain this deadweight loss


APPENDIX G: HOW SOCIETY LOSES FROM MONOPOLY (CONT’D)

As a result of monopoly, consumers are worse off in two ways: The monopoly profits that result constitute

a transfer of a portion of consumer surplus away from consumers to the monopolist

The failure of the monopoly to produce as many units as would have been produced under perfect competition eliminates consumer surplus that otherwise would have been a benefit to consumers


FIGURE G-2 LOSSES GENERATED BY MONOPOLY

chapter 11a/24

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